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Tuesday, December 16, 2014

OIl's Great Fall: This Time, The Bailouts Will Be Harder

In a desperate move, Russia's central bank recently raised a key interest rate by 6.5% to 17%, propping up the ruble at least momentarily. This was after the ruble had already lost about 50% of its value in the past few months. Even if the ruble stabilizes, Russia verges on economic collapse.

Venezuela was already hitting the skids when the price of oil began its big swoon. Now, it will possibly default on its sovereign debt. Other oil producing nations are hurting, too. Some could survive by drawing down their financial reserves. Others may not have adequate reserves on which to draw.

The impact of the oil price drops on major financial institutions and financial markets players is much more opaque. When a key commodity like oil, and the currencies issued by its producers, belly flop as we have seen in the past few months, big losses are inevitable. Some of these losses could be greatly magnified by the leveraging effect of derivatives. A crucial question for regulators is where these losses are landing. Surely there are losses on Wall Street and in the City of London. But proportionately much greater losses may have been sustained by Russian and other European banks. Dec. 31, 2014 will mark the close of financial reporting periods for many banks and other institutions. At that point, they will be required to disclose their financial conditions. It wouldn't be surprising if the losses are big. Talk of bailouts might follow.

It's one thing for the taxpayers of a nation to bail out the banks of their own nation. They may be frustrated and outraged, and demand the punishment of bank executives and others. But they have a strong interest in preserving their own financial system. It's another thing when a foreign country wants a bailout, just after it sent its Special Forces surreptitiously into a neighboring country to seize territory by force, lied to the world about what it was doing, and then made aggressive moves against many other nations--especially those that border it and have historically been dominated by it. The West has imposed sanctions on Russian banks. It can't now bail them out. It's attempting to force Russia out of Ukraine, using financial leverage as a key weapon. It can't provide Russia with a financial bailout.

Venezuela has for years been seriously hostile toward the U.S., while getting cozy with Cuba. Its current predicament is the result of spending way more than it was taking in. A bailout for Venezuela has no chance of receiving Congressional approval, nor would American generosity do anything to ameliorate the key problem, profligacy by the Venezuelan government in order to win over voters. The IMF would impose financial discipline on the Venezuelan government as a condition of any international bailout, something the current Venezuelan government surely wouldn't accept.

Free market advocates have railed for years about the bailouts made in the aftermath of the 2008 financial crisis, proclaiming that handouts to the wealthy and powerful would only foster moral hazard and encourage undue risk taking at the expense of taxpayers. They may have their way in the wake of oil's great fall. Some of the key players likely to need a bailout won't be getting them. Chips will fall where they may, and we'll see how the markets operate in the absence of government intervention. The results will be good for some, bad for others, and undoubtedly painful for many.

A destabilized Venezuela will probably experience internal political change. But a destabilizing Russia is much less predictable. As long as Putin is in power, who knows what will happen? And what is the potential for Putin to leave power? Not much and it's not likely to happen in a gracious way. Demagogues at risk of losing power sometimes turn to foreign adventurism to stay in control. The farther oil prices drop, the harder these questions will become, and the more disturbing the potential answers.

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